Tag: Fees and expenses

SEC Targets a Venture Capital Fund Manager

Frost Management Company was what seems like a typical venture capital fund complex that had raised five private funds and invested the capital in a portfolio of start-up companies.  The SEC says it found undisclosed affiliate payments and brought a suit against Frost.

Frost was an “exempt reporting adviser” with a filing from 2017. It apparently failed to file to renew the filing.

Before jumping into the charges, the first item to note is that the anti-fraud provisions of the Investment Advisers Act apply to all advisers. It doesn’t matter if you’re registered, unregistered, or exempt reporting. Those undisclosed fees will get you in troubled regardless of the firm’s registration status.

Frost caused its portfolio companies to pay incubator fees and, in some instances, monitoring fees that were not properly disclosed to investors. The SEC claims that those fees impacted the performance of the portfolio companies. That poorer performance affected the investors in the Frost venture capital funds and therefore was fraudulent, deceptive or manipulative.

The SEC seems to be hedging its argument by also claiming that the fees charged were”excessive.” In some of the five funds there appears to be some instance of disclosure. The actual process for determining the fees did not match the disclosure.

Mr. Frost apparently lost an investor arbitration case at the end of 2018 and wound down its incubator.

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Most Frequent Advisory Fee and Expense Compliance Issues

Last week, the SEC’s office of Compliance Inspections and Examinations released a risk alert on Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers. It was a bit shocking.

Shocking mostly because the issues are mostly mechanical procedural errors that were contrary to the investment advisory agreement:

  • Using a different valuation method (cost versus fair value)
  • Using the market value at the end of the billing cycle instead of an average value
  • billing monthly instead of quarterly
  • billing in advance instead of in arrears

These are obvious mistakes, but not necessarily adverse to the client.

Others deficiencies did lead to increase costs to investors:

  • Failure to prorate for a partial billing cycle
  • Applying a higher rate
  • Charging additional fees
  • Charging more that the agreed to maximum rate
  • failing to aggregate client accounts for members of the same household which would have qualified the accounts for a discounted fee

 

Although the Risk Alert is focused on retail investment advisers, private funds do not get by unscathed.

OCIE staff has observed advisers to private and registered funds that misallocated expenses to the funds. For example, staff observed advisers that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contravention of the applicable advisory agreements, operating agreements, or other disclosures.

 

 

Disclosing Private Fund Expenses to Investors – You Can’t Fix it With Form ADV

Private Fund CCOs have been focused on the disclosure and reporting of fund expenses for years. The Securities and Exchange Commission made it a centerpiece of exams of private fund managers. A handful of cases came out in 2015-2016 on that first wave of private equity fund manager exams:

  • Blackstone failed to fully inform investors about benefits it received from accelerated monitoring fees.
  • Apollo failed to adequately disclose the acceleration of monitoring fees upon the sale or initial public offering of portfolio companies.
  • WL Ross failed to disclose to funds and their investors certain fee allocation practices that resulted in the funds paying the manager approximately additional, undisclosed management fees.
  • First Reserve failed to disclose conflicts of interest related to fees and expenses charged to funds under its management, and other undisclosed benefits.

Last month, TPG Capital was the latest firm to fall under the wrath of the SEC for what the SEC decided was inadequate disclosure on fees. The focus was on acceleration of portfolio company monitoring fees.  The SEC has stated that it does not like these fees unless they are fully disclosed.

TPG charges each of its portfolio companies an annual fee in exchange for rendering a consulting and advisory services. These monitoring fees paid by each Portfolio Company to TPG are in addition to the annual management fee paid by the Funds’ limited partners to TPG. However, a certain percentage of the monitoring fees are used to offset a portion of the annual management fees that the Funds’ limited partners would otherwise pay to TPG. The standard agreement for the monitoring fee was for 10 years, with full acceleration on the sale of the company.

The SEC acknowledge that TPG disclosed its ability to collect monitoring fees to the Funds’ limited partners prior to their commitment of capital, it did not disclose its receipt of accelerated monitoring fees in the PPMs and LPAs. TPG did make fee disclosures LPAC reports, portfolio company Form S-1 filings, and TPG’s Form ADV. But the SEC took the position that by the time these disclosures were made, the limited partners had already committed capital to the Funds.

One point that had been rolling around compliance circles was how to remedy fund documents for legacy funds that did provide the level of detail on fees and expenses that the SEC now seems to require. One method was to make the disclosure in the ADV Part 2 Brochure. This case seems to blow-up that tactic.

Regardless, it would seem as a result of this action, TPG’s Form ADV Part 2 Brochure has one of the lengthiest and most detailed fee disclosure I have seen.

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The One With the Pilfering Partner

Expenses charged by private equity managers to their portfolio companies and their funds has been on the SEC’s radar since Dodd-Frank. Apollo Management was one of those caught with improper fee calculations last year. One item mentioned was the inappropriate expenses charged to the funds by one of its partners. We got more detail on that issue when the SEC brought charges against Mohammed Ali Rashid, a former senior partner at Apollo Management.

From at least January 2010 to June 2013, Mr. Rashid allegedly misappropriated $290,000 from the Apollo funds my charging personal expenses to the funds and their portfolio companies. The SEC states that there more than one thousand personal items and services charged to the funds.

Apparently, it first started in 2010 when Apollo discovered the personal charges and made Mr. Rashid repay those costs. But that did not stop him. Apollo found more instances and ended his employment in February 2014.

According to the complaint, he took steps to conceal the charges. He identified a personal salon trip as a business lunch in one instance. It was his administrative assistant that turned him in the first time. She found problems with the expense reimbursement forms for a restaurant she could not find. She ran the problems up the management chain.

Undeterred by the scolding, he continued using the corporate account as a personal charge card. He claimed to purchase items identified as gifts to portfolio company executives. Gifts they never received. He charged a personal vacation to the fund, claiming it was a business trip.

His assistant turned him in again when he falsified a clothing purchased. He had pre-approval from compliance to spend $3500 on ties to some of the portfolio company executives. When his assistant called the store for a receipt, it turned out to be a charge for Rashid’s father’s suit. Apollo slapped him on the wrist again and made him re-pay these inappropriate charges.

The firm took what seems to have been the appropriate steps and ran a full forensic review of Mr. Rahid’s expense account. As a result of the review, Apollo placed him on unpaid leave. Mr Rashid self-identified $220,000 in improper charges. The review came up with an additional $60,000. All of which he re-paid as Apollo showed him the door.

According to the SEC complaint against the firm, Apollo had self-reported the problem to the SEC.  That did not stop the SEC from including this problem in the larger order related to improper fee charges to the funds last year.

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Improperly Allocating Broken Deal Expenses

The Securities and Exchange Commission has been looking at fees and expenses at private equity funds for several years. Two years ago it brought a case against Kohlberg Kravis Roberts & Co. for misallocating more than $17 million in “broken deal” expenses to its private equity funds. An SEC investigation found that from 2006 to 2011, KKR incurred $338 million in broken deal or diligence expenses.  Even though KKR’s co-investors, including KKR executives, participated in the firm’s successful transactions efforts, KKR largely did not allocate any portion of these broken deal expenses to them.

The SEC just brought a similar case against Platinum Equity. According to the SEC’s order, from 2004 to 2015, Platinum’s funds invested in 85 companies, in which co-investors connected with Platinum also invested. Platinum incurred broken deal expenses that were paid by the funds. While the co-investors participated in Platinum’s successful transactions and benefited from Platinum’s sourcing of the transactions, Platinum did not allocate any of the broken deal expenses to the co-investors.

Platinum did not have a standing co-investment vehicle. Platinum used a separate investment vehicle to co-invest in each transaction. While there was some overlap in the co-investors from deal to deal (officers, directors, executives, and employees of Platinum), the co-Investors varied from transaction to transaction. The co-investment vehicles required payments of a pro-rata share of expenses related to the investment. There was no arrangement for Platinum to charge co-investors for broken deal expenses.

It’s tough to address the broken deal expenses for co-investments. There is no vehicle to create the contractual obligation for reimbursement. Of course, it is not right for the fund investors to bear all of the costs if the fund manager is having so many co-investments.

At least it’s not right if it’s not disclosed in the fund documents. That is what the SEC pointed out in the order. The allocation of the broken deal expenses to the fund was not disclosed in the fund documents. That could be fixed by stating that the fund pays for the broken deal expenses even when there are co-investors. Assuming you can get investors to agree to that.

This is also the first case I have noticed that the SEC has self-imposed the Kokesh limitation on disgorgement. The Kokesh case said the the SEC’s power of disgorgement was limited to going back five years. Even though Platinum was improperly allocating expenses back to 2004, the disgorgement only goes back five years to 2012.

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Another One with Improper Fees Charged to a Private Fund

For years, the Securities and Exchange Commission has been focused on fees and expenses allocated by a private fund managers to their sponsored funds. The latest to be caught improperly allocating fees and expenses is Potomac Asset Management.

First, Potomac improperly charged $2.2 million in fees to the fund for services provided by Potomac to a portfolio company of Fund I. After the portfolio company subsequently reimbursed the cost of the fees, Potomac failed to offset those fees against the management fees it charged to Fund as required by the fund documents. That meant Potomac earned a larger advisory fee that was in violation of the fund documents and was failed to be disclosed on Form ADV.

Second, Potomac improperly used the Funds’ assets to pay some expenses that should have been paid by Potomac. An individual with the title of “Principal”, who was required to perform at least 35 hours of “consulting” per week, and who was treated internally as a Potomac employee was billed to the fund improperly. Potomac also billed office rent to the fund.

The fund documents provided:

In general, [Potomac] shall bear compensation and expenses of its employees and fees and expenses for administrative, clerical and related support services, maintenance of books and records for the Fund, office space and facilities, utilities, and telephone insofar as they relate to the investment activities of the Fund. All other expenses will be borne by the Fund.

Third, Potomac used fund assets to pay costs associated with the Potomac’s regulatory obligations. Potomac charged some of the costs associated with the SEC exam and enforcement investigation to the fund. [That is always a big mistake.]

Fourth, the Funds’ audited financial statements failed to disclose these payments as related party transactions. Because the financial statements did not reflect the related party relationships and material transactions, they were not prepared in accordance with Generally Accepted Accounting Principles . Therefore, Potomac did not have a good audit under the Custody Rule. That left Potomac outside the audit exception for private funds and in custody of client assets in violation of the Custody Rule.

Fifth, the general partners of the Funds, failed to timely make certain capital contributions to the Funds as required by the terms of the Fund documents.

I don’t see any novel items in this list of mistakes and misdeeds. The SEC has been speaking about these concerns and bringing actions against firms who have done similar things. The first three items are only wrong to the extent it’s in contravention of the fund documents. Many fund managers are getting more explicit in the fund documents about what expenses can be charged to the fund. Although, I don’t think many fund investors would accept fund documents that allocated those expenses to the fund.

It has been a few months since I have seen a private equity fees and expenses case. It’s a good reminder to make sure funds are following the fund documents.

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California’s Private Fund Disclosure Bill

California’s soon to be enacted new law, AB 2833, requires every California public investment fund to require its alternative investment vehicle fund managers to make disclosures regarding fees and expenses.

welcome-to-california

AB 2833 mandates that that every California public investment fund (that includes CalSTRS and CalPERS) must make the following disclosures at least annually:

  • The fees and expenses the fund pays directly to the alternative investment vehicle, the fund manager or related parties.
  • The fund’s pro rata share of fees and expenses that are paid from the alternative investment vehicle to the fund manager or related parties. In lieu of having the alternative investment vehicle provide this information, the fund may calculate it using information contractually required to be provided by the alternative investment vehicle.
  • The fund’s pro rata share of carried interest distributed to the fund manager or related parties.
  • The fund’s pro rata share of aggregate fees and expenses paid by all of the portfolio companies held within the alternative investment vehicle to the fund manager or related parties.
  • Any additional information already required to be disclosed under the Public Records Act in regards to alternative investments.

The law defines “alternative investment” as “an investment in a private equity fund, venture fund, hedge fund, or absolute return fund.” That leaves me wondering if the term is intended to include real estate funds.

 The bill applies to new contracts that the public investment fund enters into on or after January 1, 2017, and to all existing contracts pursuant to which the public investment fund makes a new capital commitment on or after January 1, 2017.

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State Line 2-welcome-to-california
CC BY
Phillip Capper from Wellington, New Zealand

SEC Brings Another Private Equity Fund Fee Case

Apollo has been variously recognized as a god of sun, truth, healing, and poetry, and more in classical Greek and Roman mythology. It’s namesake private equity firm has settled charges with the Securities and Exchange Commission that it was less than truthful in disclosing fees charged to investors.

Giuseppe_Collignon_-_Prometheus_Steals_Fire_from_Apollo's_Sun_Chariot,_1814

The main thrust of the Apollo case was over monitoring fees. Apollo, like many private equity firms, charged a monitoring fee to its portfolio companies. The SEC has previously announced its distaste for these fees, especially when the fees relate to periods after the sale of the portfolio company.

Apollo disclosed in its fund documents that it charge monitoring fees. The SEC felt that Apollo did not adequately disclose that sometimes these fees would be accelerated upon the sale of a company and therefore earn a fee for period where there was no company to monitor.

I believe this practice has largely stopped in the private equity world or the disclosure is now more robust regarding this standard industry practice.

Regardless, it was a big chunk of change. The order lists $37 million of disgorgement.

In addition to its distaste of monitoring fees, the SEC did not like a loan from the funds to the management company. It’s not clear from the order what was going on with the loan, but it looked like a vehicle to defer taxes on carried interest. The fatal flaw for the SEC was that the accrued interest on the loan was allocated to the fund’s GP which was not fully disclosed in the financial statements.

Lastly, one of Apollo’s senior partners charged personal items to the funds in violation of the Apollo’s policies. This conduct was repeated. Apollo ended up firing the partner and making him (or her) repay the expenses. Apollo self-reported this to the SEC.

But still the SEC decided to include that expense infraction in this order.

Private fund compliance professionals have been focusing on fees and expenses. To me the monitoring fee is a leftover from a few years ago when the SEC announced its distaste for the practice. It’s not clear to me what impact the loan had on the fund investors.

Clearly, the fund investors were made whole by the malfeasance of the senior partner. Apollo did everything right in that context, including self-reporting. I’m not sure why the latter item had to be part of a big, public enforcement action.

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Charging Fund Investors For In-House Legal Staff

In house lawyers fall into two sections of typical fund documents. On one had, fund documents usually state that the fund pays for legal expenses. Another section states that the general partner is responsible for employee expenses.

Cash in the grass.

Can you charge in-house legal staff as a fund expense?

It depends.

This was mentioned by Marc Wyatt, Deputy Director – Office of Compliance Inspections and Examination, US Securities and Exchange Commission, at .

It’s not that a fund manager is prohibited from charging its fund clients for in-house legal counsel. As with any fee or expense, it needs to be properly disclosed and properly documented.

I have heard that at least one real estate private fund manager has received a deficiency letter after an examination because of the way it treated legal expenses. The fund manager charged internal legal staff compensation and expenses to the fund.

The SEC relied on the provisions in the fund documents stating that overhead, including compensation of personnel, is to be paid by the general partner / fund manager.

The general partner / fund manager pointed to other language that stated it could charge the funds for legal expenses.

I think the SEC thinks that in the case of a tie, the fund investors should win.

If you charge in house legal fees to fund investors, there are some steps a fund manager should take:

  • Disclose it on Form ADV.
  • Disclose it in the financial statements for the funds. To be in accordance with GAAP, related party transactions must be included in the notes to the financial statements.
  • Maintain timesheets and other documents to support the time or work of in-house legal staff.
  • Maintain written policies and procedures to address when the expenses should be paid by the fund and when they should be paid by the fund manager.

It may not actually be costing the fund any more for in-house versus outside cost. In fact, it may actually be cheaper.  But it is extra revenue to the fund manager. The SEC has indicated that it cares about that difference.

Delaying Losses To Earn Current Fees

Fee structure is a guiding force for how fund managers operate and a keystone for compliance professionals. A compliance professional needs to focus on ways that a fee structure could cause the fund manager to act to the detriment of fund investors. The Securities and Exchange Commission just charged a fund manager for using distorted timing to generate more fees.

Cash in the grass.

According the SEC complaint, Hope Advisors and its principal owner, Karen Bruton, distorted the trading patterns of its hedge fund it managed to maximize fees to the detriment of fund investors. Hope Advisors and Ms. Bruton are challenging the charges so I’m looking at the complaint as an example of problematic behavior and not that they actually did these things.

Hope was entitled to an incentive fee of 20% of any realized gains during the previous month. But first the fund needed to make up for any realized losses. Unrealized gains and unrealized losses were not used in calculating the incentive fee.

The PPM for the fund discloses that the incentive fee may be paid even though the fund is experiencing unrealized losses.

According to the SEC, Hope was causing the fund to realize gains currently by deferring current unrealized losses through options. The fund would sell call options in the current month, earning a fee, and buy an equivalent set of options that expired in the next month. The SEC claims that there was no economic substance to the trades because there was little chance to make or lose money regardless of the market’s direction.

The fund would keep kicking the unrealized losses into the next month, while still taking fees. The fund had an NAV of $136 million, with unrealized losses of $57 million.

According to the statements in the complaint, it seems that Hope was acting to the detriment of fund investors. However, this behavior and risk is disclosed in the PPM.

Is disclosure enough for this circumstance?

I think trades that have no economic benefit (or risk) to the fund investors but are done merely to increase a fund managers compensation are suspect. Compliance professionals should look closely to see if the trade is merely done to benefit the fund manager.

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